Another "line in the sand" but no "shock and awe"

So in the middle of the night European leaders concluded yet another crisis meeting. Whilst a major step in the right direction the deal is far from the “Grand Plan” promised many weeks ago. The initial knee jerk equity market reaction this morning is positive, but probably as much because the agreement is better than the markets feared as anything else. A sustained rally in European equity markets on the back of this announcement seems unlikely. However, the agreement itself is meaningful and the measures it proposes and the message it sends should be sufficient to underpin the markets and prevent the downward spiral many commentators feared over recent weeks.

What has been announced so far is a framework agreement centred on the three areas of Greek debt, Euro zone bank recapitalisation and the European Financial Stability Fund (EFSF) bailout fund.

Announcements so far include:

-A 50% Greek debt write-down for private-sector investors that is voluntary. The ECB doesn’t take any write-down on its Greek government bond holdings.

-The write-down should see Greek debt decline to 120% of GDP by 2020.The Greek bail-out is worth EUR130bn, with €100bn coming from the EFSF and €30bn from the IMF.

-EU leaders say it is up to the ECB what it does with its existing bond purchase plan. The EU has "no demands or requests" of the ECB.

-There is a EUR106bn bank recapitalisation plan that should take 9 months to implement. Restrictions will remain in place with respect to dividends and bonuses until capital targets have been achieved. The possibility that bond holders may be forced to participate in a “bail-in” is also mentioned.

-The EFSF is to be leveraged "4 or 5" times, suggesting that it will have a capacity of about EUR1trn, including “risk insurance” on newly issued sovereign bonds. France will contact China on Thursday about providing finance to the rescue package.

-The ECB will not be involved in leveraging up the EFSF. Ultimately we believe the ECB will need to be more meaningfully involved in the ultimate solution.

-Italy and Spain are pledging new austerity commitments.

These are the most important features. What is not announced is any detail and this will emerge over coming weeks. As ever the devil will be in the detail.

KBI’s View on the Package

For me a major conclusion from this summit is that once again European leaders when pushed will continue to defend the Euro and Eurozone, no matter what pain or tactics this will involve. They clearly judge the consequences of a breakup are inconceivable. Merkel’s passion in the debate preceding the Bundestag vote early yesterday morning underlies that belief. This determination should dispel much of the recent noise about member states exiting the Euro.

To summarise the “European outlook” right now would merit a thesis and so in this short note I will focus on three key questions I believe are immediately important to contemplate:

a) What is the outlook for economic growth? As has been the case in Ireland over recent years, the co-existence of government austerity and bank deleveraging is inherently deflationary and dampens medium term growth projections. We don’t know the economic growth assumptions that the summit has used in its calculations, but markets will watch out for these and I would be concerned that, when announced, the markets will conclude them as overly optimistic. Even with further austerity measures and the 50% private sector haircut, Greece still will only get to 120% debt to GDP ratio by 2020. However what GDP growth number projection is this based on?

b) What does it mean for the banking sector? The draft communiqué from the summit says that banks must “enhance capital” and at the same time “avoid a credit crunch” by lending. Sound familiar? As has been challenged already in Ireland and the UK this appears to be a contradiction in terms. In such circumstances many lenders already have begun to shrink their balance sheet loan books rather than diluting their equity base by issuing even more equity capital and consequently diluting shareholders. I believe that the combination of these seemingly contradictory demands and uncertainty in relation to the “how much and from where” of capital raising should continue to weigh on the banking sector. In many ways the path that the Eurozone is recently starting on is similar to the one taken by Ireland 12 months ago. From an Irish bank sector perspective the summit conclusion is seemingly that Irish banks will not be required to raise any further capital, which is relatively positive news.

c) What does it mean for Ireland? In a relative sense, I would argue that Ireland now in many ways is emerging as the poster child solution for what many other parts of Europe need to do: bank recapitalisation, fiscal austerity, restructuring etc. and all within the confines of a relatively strong currency. And we know that to date Ireland is receiving plaudits for meeting its targets. In an absolute sense it cannot be good news as the reality is that more meaningful deleveraging, fiscal austerity and restructuring in other parts of Europe will only further depress the economic growth outlook for the Eurozone as a whole, thus impacting the demand for our exports.

The other question of late is can we get better funding terms on our debt or even get our own “haircut” now that Greece has set a precedent. On the former it is possible but we don’t really have any details yet. On the latter whilst a very interesting issue to debate as has been the case in the local media lately, much official commentary since last night has made continued reference to the “uniqueness” (or uniquemess!!) of Greece. This is being literally interpreted as the defence against any other nation trying to obtain similar haircuts, hence the notion of ring fencing the Eurozone from the “unique” Greece situation.

In conclusion, Europe has been turning in the right direction and I believe it will now be 2 steps forward, 1 step back rather than vice versa. However, it will continue to be a difficult upward struggle as the many complex issues and problems will take years and not one night in Brussels to solve. I believe that the ECB will have to be central to any final solution for Europe and last night they were clearly on the periphery. For equity markets, after a grizzly September they have been strong in October and I expect the agreement reached last night should underpin them further. There is a world beyond Europe, markets move on and I believe there is now a good chance the headlines won’t be as totally fixated on Europe. I remain positive on the US economy and emerging markets. Recent macro data and earnings from both these regions have been reassuring of late and key reasons behind the market rebound. I expect this to continue to be the case. For Europe much done but much more to do.

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